The International Monetary Fund says Australia’s largest four banks should be forced to raise billions of dollars in extra capital, a move that would hit profits, because of their dominance over the industry.

Raising concerns about aspects of the banking system, the Washington-based fund called for tougher stress tests to assess how the banks would manage a financial crisis like the one that hit after the Lehman Brothers collapse.

It proposed an upfront fee paid by banks to insure depositors’ cash, a step designed to avoid expensive government bail-outs.

The report is unusually tough – Australia’s banking system was praised around the world for surviving the 2009 financial crisis mostly in good shape.

Analysts said tougher protections for the banking system would hurt returns to shareholders and have a knock-on effect across the economy because banks make up a third of the sharemarket and a major source of dividend payments.

“The more capital a bank has, the more difficult it is to get an attractive return and therefore the lower the share price," said BBY bank analyst Brett Le Mesurier.

The IMF believes the dominance of the
Commonwealth Bank of Australia
,
Westpac Banking Corp
,
ANZ Banking Group
and
National Australia Bank
, which hold 80 per cent of banking assets and 88 per cent of residential mortgages, creates dangers for the economy.

Banking more Concentrated than other countries

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That level of concentration is almost double the average of the largest four banks in other developed countries’ bank systems, it says.

“Australia’s financial sector faces a unique set of risks," the IMF said. “Its banking sector is concentrated, dominated by four large banks, and their broadly similar business models and reliance on offshore funding leave them exposed to common shocks and disruptions to funding markets.

“Against a still-worrying global environment, these risks will need to be closely monitored, particularly if the domestic economy slows sharply."

Higher capital reserves, which safeguard banks from rising bad debts, would help protect them from a sudden economic downturn or crisis.

It noted that Australia’s financial system had grown rapidly, with assets at about 340 per cent of GDP, due to the expansion of home loans and tax-effective superannuation.

The report highlights risks to banking including high household debt, high property prices and the industry’s dependence on volatile offshore funding markets.

The IMF’s Financial System Stability Assessment was published on Friday after a visit to Australia between May and July by IMF officials.

Calls for greater transparency

The report calls for more transparency by the Council of Financial Regulators, including publishing the council’s deliberations in the Reserve Bank of Australia’s Financial Stability Review.

Stress testing of the biggest four banks and Macquarie Group by the IMF and Australian Prudential Regulation Authority suggests banks are likely to withstand severe shocks, including scenarios where there was a severe recession and bank-run type scenario.

Banks would require liquidity support from the RBA to withstand an extreme funding shock.

The IMF argues that the stress test process can be improved.

“There is a need for APRA to devote more resources to bottom-up stress testing to validate and cross check individual bank results and to ensure overall consistency.

“The RBA should consider establishing its own macro-financial stress testing framework, which could enhance its ability to identify and monitor emerging systemic risks," the IMF says.

APRA chairman
John Laker
said last week it was expanding the resourcing for stress testing.

Currently, individual banks apply their own varied approaches to estimate losses given defaults (LGDs) and probabilities of defaults (PDs), and use data of different levels of granularity.

Analysis difficult for APRA

While they are required to apply APRA-determined credit migration matrices, the dispersion in banks’ practice makes analysis difficult for APRA.

“Hence, there is a need for APRA to devote more resources to bottom-up stress testing to validate and cross check individual bank results and to ensure overall consistency."

While the IMF says Australia’s banks are well capitalised with good asset quality, it says a higher capital threshold for the systemically important institutions is desirable to further bolster financial system stability.

“The four major banks are systemically important, which imposes a negative externality on the domestic financial system."

“Significant and protracted difficulties in any one of them would have severe repercussions for the entire financial system and, in turn, the real economy."

Big four should share cost of implicit guarantee

“The four major banks enjoy a funding cost advantage derived from an implicit government guarantee, and should bear some of the cost of mitigating systemic risk," it says.

International regulators are developing guidelines for domestic systemically important banks to take effect in 2016. The big four and Macquarie will qualify. APRA will consider adopting higher capital ratios, but is not necessarily wedded to the idea.Any move to further increase capital levels could restrict banks capacity to increase dividends to shareholders, particularly as their net interest margins come under pressure due to elevated funding costs and weak credit growth.

Analysis by Credit Suisse shows the big four banks, which have an average harmonised common equity ratio of about 10 per cent, are in the upper quartile for capital ratios compared to global peers, behind only Scandinavian banks.

They are already being forced to increase their capital levels under the global Basel III rules that will be phased in from next year.

“APRA’s conservative approach on capital definitions means that Australian banks hold more capital than otherwise would be the case," Australian Bankers’ Association chief executive Steven Münchenberg said.

No Australian bank was included on the Basel Committee on Banking Supervision’s list of global systemically important financial institutions (G-SIFIs) which will be forced to hold extra capital.